Are Solar Stocks Too Good to Be True?

High growth and low valuation can be found everywhere in the solar industry. But is it a dangerous mirage to investors?

What if I told you there was an industry you could invest in that was growing more than 50% per year? What if leading companies in that industry had gross margins of 20%, 30%, even 40%? And what if I told you those stocks traded with single-digit P/E ratios? Wouldn't that sound too good to be true?

That's exactly where we are in the solar industry right now. Companies are trading at multiples usually reserved for industries with no prospect for growth or companies slowly going out of business. But solar is neither of those things, and it appears that the industry's stocks are extremely undervalued on the surface.

There are a lot of factors to consider, and below I've outlined two that leave me very bullish and two that make me think about running for the hills from solar stocks.

Positive: Value too good to pass upUsually a P/E ratio under 10 and a PEG ratio (price to earnings growth) under one means a stock would be well into the value stock category. But many of solar power's biggest manufacturers trade with very low forward P/E ratios, PEG ratios below one, and have very high growth rates to go along with that value.

Company

1-Year Revenue Growth

Forward P/E Ratio

PEG Ratio

LDK Solar(NYSE: LDK)

128.5%

3.66

0.15

JA Solar(Nasdaq: JASO)

222.4%

4.43

0.35

Hanwha SolarOne(Nasdaq: HSOL)

106.4%

5.60

0.38

Suntech Power(NYSE: STP)

71.4%

8.88

1.06

Yingli Green Energy

78.5%

6.47

0.36

Source: Yahoo! Finance and Fool.com.

All of these companies are growing rapidly along with the solar market and look like incredible values. Even if profit falls as pressure hits panel prices, it looks like there's more than enough cushion to handle it. But there's a common risk as well.

Negative: China should scare you at least a little bitThe companies I've highlighted above are all Chinese stocks that have to be suffering some decreased value because of the turmoil hitting some of their counterparts. If you don't know what I'm talking about, do a Google search for China MediaExpress, Puda Coal, or any of the other Chinese stocks that have come into question.

I'm not suggesting in any way that any of these companies are frauds, lying about financial records or reporting sales and contracts that don't exist. I am saying that I've seen many companies people thought were of quality turn into a complete dud. Forbes China even made China MediaExpress its top "Up-and-Comers" stock of 2011. Now the stock is on the Pink Sheets, and investors are licking their wounds.

This is the kind of thing that keeps a Fool like me up at night. I don't want to recommend a stock or buy a stock that is going to end up like China MediaExpress. Beware of China!

Positive: Solar is the futureYou can debate among yourselves whether solar power is really the future of energy, but this Fool is drinking the Kool-Aid and driving the solar bandwagon. I think we'll look back in 50 years and laugh about the days when we got most of our energy from dirty coal and oil.

I'm seeing costs fall for solar power and rise for other energy sources and wondering how this could not be the future? Yes, there are challenges like energy storage and the intermittent nature of solar and even wind power, but I think these are challenges we can overcome with a little engineering muscle.

To me, this is like getting in on the tech boom in the early '80s. If you pick the right stock and hang on for the ride, we should be headed much higher.

Negative: Margins are going nowhere but downIt's not a secret that the first half of the year has seen panel prices fall, margins get squeezed, and solar stocks fall as a result. Some investors see these falling prices and can't see the end to the pain. If they're right, profits will continue to fall and these stocks that look cheap will look expensive very quickly.

Second-quarter results and management comments should give us some insight into how this negative for the solar industry is playing out.

What to do now?If you're a believer in solar, I think there are two ways to invest in it. You can choose the large, safer, U.S.-based companies First Solar(Nasdaq: FSLR) and SunPower, which don't have the same upside but probably won't leave you broke. Or you can pick a basket of your favorite higher-risk solar stocks to spread your risk. I've added LDK Solar to start this strategy, and I'm considering adding Trina Solar and/or Yingli Green Energy to round out the group.

What investors need to avoid is companies that are falling behind because of inferior products such as Energy Conversion Devices(Nasdaq: ENER) and Evergreen Solar(Nasdaq: ESLR). These stocks have been a sinkhole for investors' money for a long time, and that's likely to continue.